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The Basics of IPOs

Thinking about launching an initial public offering for your company? Get oriented with this step-by-step guide.

Opinions expressed by Entrepreneur contributors are their own.

The dotcom bust of 2000 put an end to the dreams of many an entrepreneur who had hoped their company's preferred exit strategy would be an (IPO) of common stock in the NASDAQ or OTC market. In fact, many business owners at the time had begun to think of IPOs as somewhat automatic in the third or fourth year after launching a business. When the internet stock craze ended, however, so did the hopes of many business owners.

These days, fortunately, to the benefit of entrepreneurs nationwide, there's renewed interest in IPOs: Entrepreneurs, venture capitalists and angel investors are once again openly discussing the IPO as a realistic benchmark.

If you're even considering the possibility of an initial public offering for your company, the following review of the natural order of IPOs will help you understand what to expect before you start the process.

The start-to-finish inner workings of a typical IPO happen like this: The company begins the process by retaining a to assist in producing a detailed firm disclosure. This will be the main content for the IPO prospectus, which must be filed with the prior to going public with the stock on the exchange. The prospectus reports on and summarizes every aspect of the company's operating life from the day it opened up for business until the date of the IPO.

Every contract, every lease, all partnership agreements and employment deals, each marketing and sales relationship, and every financial statement-these are all disclosed in a chronological format that outlines the life and development of the company over the course of time. The rationale is to provide outside investors with a comprehensive due diligence on all the potential risks associated with investing in the company.

This disclosure will also include any pending legal matters involving the company, as well as the business's interaction with various government agencies, from building code regulations all the way to IRS tax issues (if there are any). It's important to note that researching and writing the prospectus is a tedious task that requires specific expertise in order to meet all the filing requirements of the SEC.

Next, while the prospectus preparation is in process, the company will interview various banks and then select one (or more) to handle the underwriting of the IPO. Sometimes, the IPO is handled by one investment bank. Other IPO's involve a "lead underwriter" heading up a consortium of two to three banks. Whatever the number, the two primary functions of the investment bank(s) are to help the company set the offering price of the stock, and then disseminate the shares among a wide range of investors in the public capital market.

By definition, underwriting involves the investment bank accepting the full risk of selling the business's shares, such that the bank actually agrees to purchase all the offered shares from the issuing company at the agreed upon offering price. It's then the bank's risk (and responsibility) to sell the shares to investors in the market. In exchange for taking this "risk of selling" off the shoulders of the issuing company, the underwriter charges a spread to the company, which is deducted from the total funds raised and retained by the bank. The issuing company receives the "net proceeds" (the difference between the total IPO offer value minus the spread).

As an example, let's say a company is selling 5 million shares at $10 each for a $50 million total IPO value. If the underwriter and the company agree on a 4 percent spread, the bank keeps $2 million-4 percent of $50 million-and then transfers $48 million in net proceeds to the company on the day of the IPO.

The issuing company doesn't have to wait and see how the market responds to the offering of its stock, as the bank has underwritten that risk and paid the company on the front end. However, the investment bank is now in charge of actually selling the shares to the public, and can actually offer the shares at a price higher than the prospectus offering price at the opening of the market's trading.

From our prior example, then, the underwriter could post the opening "asking" price on the NASDAQ at $10.50 and write orders from buyers for 2 million shares, then raise the asking price, or "ask," to $10.75 or $11 and sell another 2 million shares. By the afternoon of the IPO date, the asking price could be at $11.25 or $11.50 and the underwriter would have ended up selling the 5 million shares at an average price of around $11, bringing in $55 million.

So the bank would have realized an additional $5 million beyond the $50 million outlined in the prospectus, leaving the investment bank happy with the IPO, having made $7 million in total profit. But the issuing company could be upset that the bank didn't advise an offer price of $11 (or $10.50, or anything over $10), which would have increased the net proceeds to the company.

The underwriter, however, accepts the risk of the IPO, with the understanding that the shares could have been offered at 10 and then could have dropped to $9.75 or $9.50 in the market, based on a lower-than-expected demand. In this case, the firm still has $48 million in net proceeds, but the bank has less than $2 million in fees (if the IPO sells out at less than the $50 million targeted in the prospectus).

Now let's get back to the next steps. Prior to the IPO date, the company and the underwriter typically head out to do a "road show," meeting with mutual fund managers, analysts and other stock portfolio managers in several large cities during the weeks leading up to the IPO date. These presentations are designed to generate dialogue between the potential stock buyers and the senior management of the issuing company, so they can discuss sales, marketing, the competition, operations, pending new products or services, and financial performance.

The underwriter uses these road shows to gauge the level of interest in the company among potential buyers, and to determine the likely IPO price that investors would pay for the shares. Please note that the IPO cannot be pre-sold during this time-no actual orders can be taken in advance of the IPO date.

During the road show, the lead investment bank will recruit a selling syndicate-an assembly of other brokerage firms that have expressed interest in helping disseminate the stock nationwide on the IPO date. This group will each buy large blocks of stock-10,000 shares or more-and then spread it out through their branch network of offices to various fund managers and other investors.

On the IPO date, the company and its team-the lawyers who compiled the prospectus and the investment bank(s) who'll handle the offering-do their last-minute edits and negotiate the final offer price, and the last version of the prospectus is filed with the SEC, usually within the half hour prior to the opening of trading on the exchange. Once the SEC gives its "OK" that the prospectus meets the minimum filing requirements-the SEC does not rule on the accuracy or the adequacy of the firm's prospectus-the investment bank opens up trading at its chosen asking price, and the selling begins.

Raising significant outside equity capital through an IPO is a major milestone in the life of a company. But with the right amount of preparation-and knowing what to expect-the prospects for doing a successful IPO can be great.

David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.

The opinions expressed in this column are those of the author, not of All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.

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